Key points

  • Aggregate supply is the total quantity of output firms will produce and sell—in other words, the real GDP.
  • The upward-sloping aggregate supply curve—also known as the short run aggregate supply curve—shows the positive relationship between price level and real GDP in the short run.
  • The aggregate supply curve slopes up because when the price level for outputs increases while the price level of inputs remains fixed, the opportunity for additional profits encourages more production.
  • Potential GDP, or full-employment GDP, is the maximum quantity that an economy can produce given full employment of its existing levels of labor, physical capital, technology, and institutions.
  • Aggregate demand is the amount of total spending on domestic goods and services in an economy.
  • The downward-sloping aggregate demand curve shows the relationship between the price level for outputs and the quantity of total spending in the economy.

Introduction

To understand and use a macroeconomic model, we first need to understand how the average price of all goods and services produced in an economy affects the total quantity of output and the total amount of spending on goods and services in that economy.

The aggregate supply curve

Firms make decisions about what quantity to supply based on the profits they expect to earn. Profits, in turn, are also determined by the price of the outputs the firm sells and by the price of the inputs—like labor or raw materials—the firm needs to buy. Aggregate supply, or AS, refers to the total quantity of output—in other words, real GDP—firms will produce and sell. The aggregate supply curve shows the total quantity of output—real GDP—that firms will produce and sell at each price level.
The graph below shows an aggregate supply curve. Let's begin by walking through the elements of the diagram one at a time: the horizontal and vertical axes, the aggregate supply curve itself, and the meaning of the potential GDP vertical line.
The aggregate supply curve
 
The horizontal axis of the diagram shows real GDP—that is, the level of GDP adjusted for inflation. The vertical axis shows the price level. Price level is the average price of all goods and services produced in the economy. It's an index number, like the GDP deflator.
Notice on the graph that as the price level rises, the aggregate supply—quantity of goods and services supplied—rises as well. Why do you think this is?
The price level shown on the vertical axis represents prices for final goods or outputs bought in the economy, not the price level for intermediate goods and services that are inputs to production. The AS curve describes how suppliers will react to a higher price level for final outputs of goods and services while the prices of inputs like labor and energy remain constant.
If firms across the economy face a situation where the price level of what they produce and sell is rising but their costs of production are not rising, then the lure of higher profits will induce them to expand production.

Potential GDP

 
At these relatively low levels of output, levels of unemployment are high, and many factories are running only part-time or have closed their doors. In this situation, a relatively small increase in the prices of the outputs that businesses sell—with no rise in input prices—can encourage a considerable surge in the quantity of aggregate supply—real GDP—because so many workers and factories are ready to swing into production.
As the quantity produced increases, however, certain firms and industries will start running into limits—for example, nearly all of the expert workers in a certain industry could have jobs or factories in certain geographic areas or industries might be running at full speed.
In the intermediate area of the AS curve, a higher price level for outputs continues to encourage a greater quantity of output, but as the increasingly steep upward slope of the aggregate supply curve shows, the increase in quantity in response to a given rise in the price level will not be quite as large.
At the far right, the aggregate supply curve becomes nearly vertical. At this quantity, higher prices for outputs cannot encourage additional output because even if firms want to expand output, the inputs of labor and machinery in the economy are fully employed.
In our example AS curve, the vertical line in the exhibit shows that potential GDP occurs at a total output of 9,500. When an economy is operating at its potential GDP, machines and factories are running at capacity, and the unemployment rate is relatively low at the natural rate of unemployment. For this reason, potential GDP is sometimes also called full-employment GDP.

Why does AS cross potential GDP?

The aggregate supply curve is typically drawn to cross the potential GDP line. This shape may seem puzzling—How can an economy produce at an output level which is higher than its potential or full-employment GDP?
The economic intuition here is that if prices for outputs were high enough, producers would make fanatical efforts to produce: all workers would be on double-overtime, all machines would run 24 hours a day, seven days a week. Such hyper-intense production would go beyond using potential labor and physical capital resources fully to using them in a way that is not sustainable in the long term. Thus, it is indeed possible for production to sprint above potential GDP, but only in the short run.
So, in the short run, it is possible for producers to supply less or more GDP than potential if demand is too low or too high. In the long run, however, producers are limited to producing at potential GDP.
For this reason, economists also refer to the AS curve as the short run aggregate supply curve, or SRAS curve. The vertical line at potential GDP may also be referred to as the long run aggregate supply curve, or LRAS curve.

The Aggregate Demand Curve

Aggregate demand, or AD, refers to the amount of total spending on domestic goods and services in an economy. Strictly speaking, AD is what economists call total planned expenditure. We'll talk about that more in other articles, but for now, just think of aggregate demand as total spending.
Aggregate demand includes all four components of demand:
  • Consumption
  • Investment
  • Government spending
  • Net exports—exports minus imports
This demand is determined by a number of factors; one of them is the price level. An aggregate demand curve shows the total spending on domestic goods and services at each price level.
You can see an example aggregate demand curve below. Just like in an aggregate supply curve, the horizontal axis shows real GDP and the vertical axis shows price level. But there's a big difference in the shape of the AD curve—it slopes down. This downward slope indicates that increases in the price level of outputs lead to a lower quantity of total spending.
 
 
Let's dig a little deeper. To fully understand why price level increases lead to lower spending, we need to understand how changes in the price level affect the different components of aggregate demand. Remember, the following components make up aggregate demand: consumption spending, start text, C, end text; investment spending, start text, I, end text; government spending, start text, G, end text; and spending on exports, start text, X, end text, minus imports start text, M, end text.
start text, A, g, g, r, e, g, a, t, e, space, d, e, m, a, n, d, end text, equals, start text, C, end text, plus, start text, I, end text, plus, start text, G, end text, plus, start text, X, end text, minus, start text, M, end text.
The wealth effect holds that as the price level increases, the buying power of savings that people have stored up in bank accounts and other assets will diminish, eaten away to some extent by inflation. Because a rise in the price level reduces people’s wealth, consumption spending will fall as the price level rises.
The interest rate effect explains that as outputs rise, the same purchases will take more money or credit to accomplish. This additional demand for money and credit will push interest rates higher. In turn, higher interest rates will reduce borrowing by businesses for investment purposes and reduce borrowing by households for homes and cars—thus reducing both consumption and investment spending.
The foreign price effect points out that if prices rise in the United States while remaining fixed in other countries, then goods in the United States will be relatively more expensive compared to goods in the rest of the world. US exports will be relatively more expensive, and thus the quantity of exports sold will fall. Imports from abroad will be relatively cheaper, so the quantity of imports will rise. Thus, a higher domestic price level, relative to price levels in other countries, will reduce net export expenditures.
Truth be told, among economists, all three of these effects are controversial, in part because they do not seem to be very large.
For this reason, the aggregate demand curve in our example aggregate demand curve above slopes downward fairly steeply. The steep slope indicates that a higher price level for final outputs does reduce aggregate demand for all three of these reasons, but the change in the quantity of aggregate demand as a result of changes in price level is not very large.

Summary

  • Aggregate supply is the total quantity of output firms will produce and sell—in other words, the real GDP.
  • The upward-sloping aggregate supply curve—also known as the short run aggregate supply curve—shows the positive relationship between price level and real GDP in the short run.
  • Aggregate supply curves slope up because when the price level for outputs increases while the price level of inputs remains fixed, the opportunity for additional profits encourages more production.
  • Potential GDP, or full-employment GDP, is the maximum quantity that an economy can produce given full employment of its existing levels of labor, physical capital, technology, and institutions.
  • Aggregate demand is the amount of total spending on domestic goods and services in an economy.
  • The downward-sloping aggregate demand curve shows the relationship between the price level for outputs and the quantity of total spending in the economy.